During the height of the real estate bubble, real estate investment trusts (REITs) were popular securities to invest in. REITs offered steady distributions of cash plus the appreciation of real estate. When the bubble popped, many speculated that REITs would be in major trouble; after all, the REIT industry is reliant upon reliable available access to capital (the cheaper, the better) and a steady rental stream from residential and commercial tenants. With both under stress, how would REITs fare?

In the short term, things have been rough. For the medium term, the ability of any REIT to increase distributions, in a de-leveraging world, will be challenged.

THE SHORT TERM

Like any other industry, REITs have had a rough ride. For the first calendar quarter, the MSCI US REIT Index fell 33%; the Asian REIT index fell 13%, the European REIT index fell 19%. The TSX REIT total return took the best of the worse award only falling 8% (versus the TSX return of -2% for the same period of time).

The reasons for the decline in the REIT industry can be chalked up to the usual suspects: real estate valuations are falling, cost of capital is increasing, REITs who started construction are under financial stress (see H & R REIT), large tenants are difficult to find (see Brookfield Properties issues in a New York City without Lehman Brothers and a shrunken financial sector as a whole), the market is moving capital away from highly leveraged industries to low-leveraged investment strategies etc. etc.

In other words, REITs are a victim of a de-leveraging world and the stock price is reflecting it.

THE MEDIUM TERM

The more fundamental and medium term issue, for those concerned about distributions, is the uncertain future affecting a REITs’ ability to increase or maintain its distribution. The root cause of this concern is the cost of capital is going up.

RioCan REIT and Calloway REIT both recently completed debt raises, issuing 5 year debentures paying 8.33% and 10.25% respectively. More importantly, RioCan announced it would be using its proceeds of its 8.33% debenture to repurchase previously issued debt paying 5.29% and 4.938%. Calloway announced it would be using its proceeds of 10.25% debenture to repurchase 4.51% debenture. All the debentures being repurchased are maturing soon.

To state the obvious: (i) both REITs are paying an extremely high rate of interest to access capital, indicating it is pricing in the fact the market perceives REITs to be risky investments; and (ii) look at the spread between the new debentures and the old ones it is replacing. The cost of doing business just went up.

What is the natural implication of a higher cost of capital? The ability of a REIT to maintain, increase or decrease its distributions depends upon its adjusted funds from operations (AFFO), in lieu of a dividend payout analysis. I wrote about calculating a REITs AFFO in the past.

A higher cost of capital means greater expenses. Greater expenses in an environment of non-tenant growth results in reduced AFFO since you have increasing expenses which is not off-set by increasing revenue (in some cases, revenue may be decreasing). Reduced AFFO, over time, will result in either a REIT maintaining or reducing its distribution.

For example, RioCan’s AFFO for fiscal 2008 was $1.31/unit but it was paying out $1.36/unit, meaning it was paying out more than it was taking in, with a payout ratio of 104%. Given that its expenses are increasing with this recent debenture issue, RioCan’s ability to maintain its distribution will be under stress. Calloway faces a similar problem- one analysts believes its increased cost of capital may reduce AFFO by 9-10 cents a unit per annum.

THINGS TO LOOK OUT FOR

If you are interested in REITs, there are a few things to look out for in this environment (and let’s assume there will not be a positive change to the REIT industry for another 12-18 months):

1. Look for loan to value ratios (LTV). You have to dig into financial reports for this. LTV is the total debt as a percentage of appraised value of a REITs holdings. The lower the LTV, the better the ability of a REIT to borrow money relatively cheaply (given it has more assets to pledge as collateral).  For example, RioCan’s LTV is estimated to be 48% while Calloway’s is at 65%. This may be one reason why RioCan could raise debt cheaper than Calloway.
2. Look at cash positions. Assuming AFFO decreases, a REIT may have to rely upon dipping into its cash to maintain its distributions. Look at cash on balance sheets as a safety net for distribution payments.
3. Use common sense. A REIT that is concentrated in Class A commercial real estate is going to have a bleaker short-term future than a REIT with mixed residential and commercial holdings. Correspondingly, a REIT with mature properties is going to have better prospects than a REIT building out lot of projects which sucks up cash. Investing in real estate stocks has a lot of common sense in it given the tangibility of the underlying asset.

Like many other investment classes, REITs are struggling as a whole. However, a REIT which has low LTV, locked in loans for the long term and a diverse holding of properties can weather the storm. Good luck.